Kroger's secret weapon

A small British market research firm is helping America's largest traditional supermarket get its customers to spend more. Take a peek inside the latest in data mining.

DunnhumbyUSA's Simon Hay is seeking to duplicate his firm's success in the U.K.

Kroger has taken a page from the book of the U.K.'s largest retailer, and now micro-targets its customers.

CINCINNATI (Fortune) -- Shoppers like Amy Thomas are ubiquitous in the aisles of American grocery stores these days. Suburban mom, 39, three young kids, works part time in a hospital.
She watches every penny, but doesn't have much time to clip coupons. "Other than for diapers, I don't clip," she says.

About three years ago, Thomas got something in the mail from Kroger (Charts, Fortune 500), her longtime grocer outside of Cincinnati, which caught her eye.
It was a pack of coupons, but not like coupons she had seen before. For starters, unlike the one-size-fits-all discounts in the newspaper, these coupons were for products that she
actually bought often, like the veggie burgers her husband likes, while others were for items she might want, like those Kudos snack bars that she once shunned as too pricey and now
buys regularly. It's gotten so that Thomas actually looks forward to those quarterly mailings from Kroger.

A harried mom eagerly awaiting what would normally be considered junk mail? She can thank dunnhumby. A British marketing consulting firm that excels in data analysis, dunnhumby has
made a name for itself in European retail circles over the past decade by helping Tesco ( TSD.Y)
rise from England's third-largest merchant to the nation's biggest by far (and No. 3 in the world), with a market share roughly double that of its closest UK rival. A key element of
Tesco's success is its Clubcard, a shopper loyalty scheme launched in 1995 that tailors discounts to specific customer segments - pet owners, say - and also gives customers money
back, based on their purchases, in the form of vouchers they can use in the store.

While the concept is far from revolutionary, the execution and evolution of the program has been profound and unique, in that Tesco truly rewards every shopper differently, based on a
deep analysis of what and how much she buys. (The man in charge of launching Clubcard, Tim Mason, is now heading up Tesco's new U.S. foray, dubbed Fresh & Easy.)

To conduct that analysis, Tesco relies on dunnhumby - a tiny London firm founded by the husband-and-wife team of math whiz Clive Humby and marketer Edwina Dunn - whose keen customer
insights quickly won over Tesco's leadership. At a 1994 meeting where Humby presented results of a Clubcard pilot program to Tesco's management, former chairman Sir Ian MacLaurin
expressed his amazement: "You know more about my customers in three months," he said, "than I know in 30 years."

Now, dunnhumby is trying to work that same magic in the United States with Kroger, the country's biggest traditional supermarket and its third-largest retailer overall, with $66
billion in sales from over 3,600 stores. In June 2003 Kroger and dunnhumby (which is majority owned by Tesco) quietly created a joint venture, dunnhumby USA, that sought to "provide
shoppers with a more customized shopping experience," according to a statement released at the time.

Since then, they've said very little. While this marriage of British ingenuity and American can-do spirit got off to a rocky start, it is now working out nicely for Kroger, whose
sales and profits have risen for two years straight. Its stock has climbed 77% since the joint venture was announced, besting the S&P 500's 44% rise over the same period. Yes,
Kroger's stores are cleaner, its prices lower, and its employees more helpful than in years past. But in conference calls with analysts, Kroger CEO Dave Dillon has referred to
dunnhumby as his "secret weapon" in the cutthroat battle against supermarket rivals like Safeway, upscale emporiums like Whole Foods, and mass merchants like Wal-Mart (Charts, Fortune 500) (the nation's largest grocer), Target (Charts, Fortune 500), and Costco.

Dillon might have a hard time keeping his weapon concealed for much longer. The partnership is generating millions in revenue by selling Kroger's shopper data to consumer product
giants like Unilever (Charts), Procter & Gamble, Kraft, General Mills, PepsiCo, Clorox, and Kellogg's: 60 clients
in all, 40% of which are Fortune 500 firms. (The data does not include personal information, like addresses.)

Frito-Lay CEO: 'I'm blown away'

For jaded retail veterans, dunnhumby's approach is a breath of fresh air. "I've been in this business 32 years, and this is the best blend of customer data and retail insight I've
ever seen," says Al Carey, CEO of PepsiCo's Frito-Lay snack business. "I'm blown away. It's given me new hope." DunnhumbyUSA has also opened an office in Atlanta to work closely with
new client Home Depot (Charts, Fortune 500), which has been criticized widely over the past few years for
losing touch with shoppers, and it is in talks with other big retailers, like Staples.

The firm has opened offices in both New York and Portland, Oregon, but there are no plans to work with Tesco's new stores on the West Coast. Simon Hay, the droll, amiable Brit who
runs dunnhumbyUSA, wants to take it slow, one shopper at a time. "What we are doing is deep and complex," he says. "We try to separate fact from fiction."

Here's why PepsiCo and others are so inspired. While customer loyalty programs have proliferated - the average American household belongs to 12 different ones - they do little to
actually generate loyalty. In fact, they can do quite the opposite, as fickle shoppers play one program off the other. Retailers don't like the programs either. They collect reams of
checkout data, but have neither the expertise nor the resources to convert that raw data into actions that would delight shoppers, increase sales, and get a return on their
investment. Some don't see the point of such programs anymore: Albertsons stores in the Dallas/Fort Worth area recently scrapped their loyalty card entirely.

Kroger's Dillon faced a similar problem back in 2001. He was COO at the time, overseeing a new loyalty card program that aspired to be "something other than a promotional tool," he
recalls. Dillon had Kroger execs Don McGeorge and Rodney McMullen scour the country for a partner who could transform Kroger's loyalty card data into actual loyalty. They had no luck.
"The data was there but no one could turn it into something useful," says Dillon.

McMullen, though, had heard of the success that Tesco was having with its Clubcard, which by then had handed out nearly one billion pounds in vouchers, yet Tesco made money from the
program thanks to the sales lift attributable to laser-targeted promotions. "Who's behind that?" he wondered. He eventually convinced Humby and Dunn to sit down with the Kroger folks
in a dark, windowless office at its corporate headquarters just outside Cincinnati. The companies agreed to run some small pilot programs together, but the results "didn't blow me
away," Dillon recalls.

Inside the secret weapon

But today, that partnership will blow just about anyone away. Inside a former overall factory on Cincinnati's riverfront, just a stone's throw from the sleek Paul Brown stadium, home
of the NFL's Bengals, the 220 employees of dunnhumbyUSA quietly and efficiently go about their work on a cloudy mid-September morning. Here, analysts with graduate degrees in
statistics sift through 300 terabytes of data representing 40 billion purchases made on four billion shopping trips by 42 million card-carrying Kroger shoppers across the country over
the past two years. They're looking for clues and patterns that help decipher not only what Kroger's top customers are buying, but why, and what actions would get them to buy more.

At its core, the dunnhumby approach assigns a score to products on Kroger's shelves based on attributes like price, quality, freshness, and the size of the package. (Organic Swiss
chard would have a much different score than, say, Twinkies.) Dunnhumby's computers then search for customers whose shopping carts have similar scores, and groups those shoppers
together into segments. Kroger right now has seven segments, such as budget shoppers, those "watching the waistline," and so-called "family-focused."

Each segment gets customized mailings, and can be further broken down if need be. When she visits her local Kroger, dunnhumby data analyst Sandy Steiger says she can usually predict
which segment her fellow shoppers belong to based on what's in their cart. The firm's clients in the consumer products industry pay hefty fees (in the high six figures) to access
Kroger's database and learn which segments are buying their brands.

Based on dunnhumbyUSA's analysis, for example, Unilever learned that Hispanics in the Southwest and Texas desired a certain flavor of Lipton iced tea - orange mango - that was not
available in their local Krogers. Unilever quickly got the product into those stores. "We can spotlight where ethnic groups tend to focus," says Art Drogue, senior VP of customer
development at Unilever.

Despite the rigor of dunnhumby's approach, it's by no means foolproof. Some Kroger shoppers complain that they get coupons for things they'd never consider buying. But a larger
problem with the mailings is that Americans, by and large, view all direct mail with suspicion. "I get the Kroger coupons, but I put them in the pile with the 'Join Netflix' mailings
and the whole thing goes in the bin," says Bettina Roberts, a graduate student who shops at Kroger in Durham, NC. In the past 15 years, annual coupon redemption has dropped from seven
billion to 2.6 billion, according to research firm CMS, which tracks coupon use. "It is difficult to get people to care about the [mailing]," admits Edwina Dunn.

While coupon redemption rates at Kroger are far higher than the 1% to 3% normally generated by untargeted offers, they are still well below the 20% average that Tesco achieves in the
UK via Clubcard. Dillon expects more. "I was generally satisfied in the beginning, I am satisfied now, and I expect to be very satisfied in the future," he says. Nobody expects Kroger
to please all of its 65 million shoppers all the time - ndeed, one big lesson it learned from dunnhumby is that it doesn't have to. Instead, Kroger is coaxing its most dedicated
shoppers to come a few more times a month, and spend a little more on each trip. And when you're battling Wal-Mart, Target, Whole Foods, and Costco, every little bit helps.